Published on Jul 21, 2020

Exposure to non-compliance can be fatal. Here, we explained why you need to conduct due diligence on compliance before you purchase a business – The Fold Legal. Exposure to non-compliance can be fatal. Here, we explained why you need to conduct due diligence on compliance before you purchase a business – The Fold Legal.

Exposure to historical non-compliance can be fatal for purchasers but many don’t include it in their due diligence. ASIC is on the warpath and you can be liable even if you weren’t operating the business at the time of the non-compliance. So before you purchase a business that holds an Australian Financial Services Licence or Australian Credit Licence you need to make sure the compliance records and policies are up to standard.

What is due diligence good for?

Due diligence is crucial to any transaction. As a buyer, it gives you comfort that:

  • The value of the business is appropriate;
  • You have the appetite for the risks associated with the business; and
  • The share sale agreement addresses these risks and exposures in exchange for due consideration.

If you don’t perform due diligence you won’t know what potential exposures you have in the business you’re purchasing.

What are the risks of historical non-compliance?

If you purchase a business with a history of non-compliance, ASIC may hold you accountable for regulatory non-compliance. This is possible even if the acts or omissions that led to non-compliance took place under the previous owner.

If ASIC finds the business guilty of non-compliance, they can impose a range of remedies including:

  • Additional licence conditions;
  • Requiring you to undertake a client remediation program;
  • Publishing a ‘name and shame’ media release. This may tarnish the business’ reputation and cause clients to panic;
  • Suspending the licence. During this time the business and its representatives cannot provide financial services or generate income;
  • Cancelling the licence; or
  • Imposing civil penalties for corporates and financial service licensees for breaching their licence conditions.

Even if the licence isn’t cancelled, you could face significant financial strain or insolvency. This could be caused by:

  • Paying the purchase price;
  • Incurring additional legal and compliance costs to defend and remediate non-compliance;
  • Representatives deciding to transfer to another licensee with a better compliance record and reputation. Operating with a reduced number of representatives may severely impact the business’ ability to generate revenue; and
  • Reputational damage and business disruption that stagnates the business.

There is also no guarantee the non-compliance is purely historical – it might be an ongoing issue that needs to be addressed at significant cost.

You can protect yourself in the share sale contract by including specific indemnities, for example. But if these protections haven’t been drafted appropriately, the cost of defending the business may be prohibitive and impossible for you to recover from the seller.

Minimise your compliance risk

As a buyer, once you’ve completed your financial due diligence, there are 4 steps you should take to minimise your compliance risk:

Step 1: Undertake compliance due diligence

  • Ask for details of any ASIC investigations or surveillances in the last 5 years.
  • Ask for audit reports for each representative over the last 5 years.

Red flag: The business doesn’t regularly audit their representatives.

  • Request details of any client compensation paid over the last 5 years.
  • Review the business’ breach register.

Red flag: The business doesn’t have a breach register.

  • Review the business’ key policies and procedures.
  • Conduct sample testing to check the quality of the business’ record-keeping practices.

If you find any issues you can require the seller to update their compliance framework and address specific issues (like client compensation) prior to purchase.

Step 2: Protect yourself contractually

When drafting the contract, include:

  • Warranties that you can rely on and indemnities you can enforce.

TIP: Draft specific indemnities for any particular issues identified during your compliance due diligence that aren’t deal breakers.

  • A remediation clause that covers any costs including fines, client compensation and legal expenses. Also include requirements for the seller to produce records and information and promise to work collaboratively and in good faith to negotiate and achieve the most favourable outcome possible for you.
  • Guarantees that can be enforced against the seller on a corporate and individual level. Obviously, these will only be as strong as the financial resources of the party giving them.

TIP: Ask for guarantees from owner directors.

  • Structuring the purchase price payment so that part of the purchase price is held in escrow for a set period of time. If compliance issues arise during that time this amount can be used to address the issue. Once the escrow period has lapsed, the amount can be paid to the seller. The length of the escrow period is a commercial point of negotiation between the parties. The longest we’ve seen them run for is 2 to 3 years.

TIP: This arrangement works best if the exposure you’re protecting against has a set ceiling. If not, indemnities are optimal contractual protection.

Step 3: Be vigilant when running the business

  • If your due diligence has identified gaps in compliance, you should address these immediately. Your compliance framework should be sufficient to prevent recurrence.
  • Consider engaging an external compliance consultant to help you determine the extent of a compliance issue and how best to fix it.
  • If clients need to be compensated for historical compliance breaches, you should expedite this program and notify the seller as early as possible.

Step 4: Review the representatives of the business

  • If you’re retaining representatives, you should review their individual compliance history. You may need to terminate a representative if they have a poor compliance history or require the seller to do so as a condition precedent.
  • You may need some employees or representatives to stay on after the purchase to assist with remediation or oversee improvements to the compliance framework. You will need to identify them and make sure they aren’t planning to terminate their employment or authorisation upon sale as this may impact your valuation of the business.

We have a lot of experience advising on the sale and purchase of financial services and credit businesses. If you’re considering purchasing a business and are concerned about compliance risk, please get in touch. We’re here to help.

Simon Carrodus

July 2020

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